The Tyranny of Bad Economics

It is often said that the there are few forces as destructive as the power of bad economics. Rarely has this been more clearly demonstrated than in the current crisis.

While the bankers’ greed fed the housing bubble, the incompetence and/or corruption of the economics profession allowed the world’s largest financial bubble to grow unchecked until its inevitable collapse wrecked the economy. Remarkably, the economists who got everything wrong as the bubble was expanding are still being given the opportunity to get everything wrong as we try to dig out from the wreckage.

Even though most of the “best” economists in the world did not see it, the story of the bubble and its collapse was in fact extremely simple. The recovery from the stock market crash in 2001 was driven by the growth of the housing bubble.

In the United States, the unprecedented run-up in house prices fueled the economy by causing a construction boom, and even more importantly, a consumption boom, as the saving rate fell to zero. While many prominent economists lectured the country on the need to save and to end spendthrift ways, those who knew economics pointed to the well-known housing wealth effect.

Households spend in part based on their housing wealth. The predictable result of the creation of $8 trillion in housing bubble wealth ($110,000 per homeowner) was a massive consumption boom on the order of $400 billion to $600 billion a year. The problem was not people’s spendthrift ways; the problem was that economic policymakers allowed for a huge bubble to develop. People treated this bubble wealth as real wealth, and responded exactly as economic theory would predict: they spent like crazy.

With house prices falling rapidly back to earth, the housing construction boom is now a bust and saving rates are returning to normal. The economy is also experiencing a collapse in a non-residential real estate bubble that developed in the wake of the housing bubble. There has been huge overbuilding in retail, office space, hotels, and most other categories of non-residential construction.

This backdrop in extremely important in assessing the “fix the banks” battle cry of the economists who did not see the housing bubble. The word from this distinguished group is that if we can get the banks lending again, then the economy will be on its way to recovery. Coincidentally, the central ingredient in their formula is throwing hundreds of billions, or even trillions, of taxpayer dollars at the banks. In other words, they want to impose huge taxes on ordinary workers to give more money to the people who were most directly responsible for the propelling the bubble.

The elite economists tell us that even if this idea might offend our sensibilities, it is the only way to get the economy going again. This is where a little basic economics would be useful again.

Suppose we snap out fingers and bring Citigroup, Bank of America and the rest of the zombies back to full solvency; what would happen? Is there any reason to believe that consumers will spend more? Remember the housing wealth effect? The bubble wealth is gone; people are spending less because they don’t have the wealth to justify the spending. We are seeing the sort of consumer spending levels that we should expect to see in the absence of a housing bubble. What part of this story can’t the elite economists understand?

Let’s turn to construction. If we fix the banks, will we see more housing construction in a glutted housing market? Will we see further overbuilding of office space and retail space? Presumably the answer to these questions is no. Fixing the banks will have little effect on either residential or non-residential construction.

Maybe fixing the banks will revive investment in equipment and software. When considering this possibility it is important to remember that large, healthy companies like Intel, Verizon, and IBM are already able to borrow money both long-term and short-term at very low rates. Therefore, investment by these companies is not likely to be affected much by fixing the banks.

This leaves investment in equipment and software by smaller, less credit-worthy companies. Undoubtedly many of these companies are experiencing difficulty getting access to capital right now. Part of the problem is due to the fact that these firms look like very bad credit risks in the middle of a steep recession, but part of the problem is due to the condition of the banks.

So, if we snap our fingers and the banks are now fixed, these smaller firms will suddenly be in a position to invest more. Equipment and software investment accounts for 7 percent of GDP. If we generously assume that the capital-starved small firms account for half of this investment, and that the bank fix will boost their investment by 50 percent, then throwing money at the banks will increase investment by an amount equal to 1.75 percent of GDP an amount that is approximately equal to half the falloff in housing construction, and less than a quarter the total drop in demand due to the collapse of the housing bubble.

In other words, the arithmetic shows that a bank fix, while desirable, cannot possibly be sufficient to offset the collapse of the housing bubble. If our priority is to save the bankers from suffering the consequences of their own mistakes, then it makes sense to throw all our money at them, but if the point is to fix the economy, then we have to look elsewhere.

Those of us who know economics recognize this fact. Those who insist on the bank fix route should be asked one simple question: “When did you stop being wrong about the economy?”Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.